A2 Milk Growing Strongly Despite Slowdown

A transition to new infant formula packaging appears to have slowed revenue growth for a2 Milk but brokers believe the share price has over-reacted.

-Revenue growth still expected to be up 64-68% in FY18
-Yet, trading on a large PE multiple leaves no room for disappointment
-a2 Milk intentionally running down old-labelled stock to limit discounting

By Eva Brocklehurst

A2 Milk ((A2M)) has guided to FY18 sales below consensus expectations, catching the market unawares and creating a downdraught for the share price.

A transition to new infant formula packaging appears to have slowed revenue growth and, while the outlook commentary is broadly consistent with the first half result, UBS suggests it implies -10% downgrades to market estimates that had assumed stronger gross margins and lower marketing costs.

The company expects FY18 revenue to be in the range of NZ$900-920m, up 64-68% year-on-year. Gross margins are expected to be in line with the first half and marketing costs to be NZ$82-87m versus prior expectations of $82-92m.

UBS reduces FY18 estimates by -5-10% to reflect the changes in guidance. Beyond FY18 downgrades are more modest, at -5-8%, and reflect a view that a2 Milk will benefit from recent increases in stage III pricing and increased penetration in China as well as the shift to higher margin products. The broker believes, at current levels, its valuation incorporates the outlook.

The update did not address all the market concerns, although Macquarie assesses the impact on channel inventory of new packaging explains a large amount of the difference to consensus expectations.

The market had assumed an acceleration of growth in the second half to 75-80%, suggested by the gains in the shares, while guidance implies growth around 50-60%. The company is continuing to actively support the daigou channel and Macquarie observes this is being carefully managed, given consumer sensitivity to the perceptions of older stock.

The company has been intentionally running down stock so that distributors are not left with old packaging, and to limit the chance of discounting.

The impact of the transition to new label formats in the June quarter appears to be larger than previously expected, Bell Potter agrees, and has taken some momentum out of revenue growth.

The broker still believes the business is high growth and, as the number of stockists in China and the US continue to increase, this is an indication of future earnings growth potential. Bell Potter, not one of the eight monitored daily on the FNArena database, has a Buy rating and $12.80 target.

Outlook

Multinationals that operate in the company's market are noting double-digit growth in consumption and management has stated that Nestle's new infant formula, Atwo, has had no noticeable impact on its sales, albeit it is early days for that product in the market.

The company's share of distribution in Australia has risen slightly to 9.6% and progress is being made in the US on its footprint. Macquarie estimates a2 Milk had an average share of 3.1% in the second half of FY17 and this has increased to 5.8% as of March 2018. Assuming this holds, it would imply around 90% growth in volume before market and pricing changes.

Citi downgrades to Neutral from Buy because of the increased uncertainty around the short-term outlook. The transition to new infant formula packaging should be a one-off but the broker remains concerned about re-seller price reductions.

Citi remains happy with the potential for infant formula growth in the long-term in China. Still, over the last few months, modest re-seller price reductions across Australian daigou stores and Chinese e-commerce platforms have been observed.

Reductions have the potential to lead to lower margins and make daigous hesitant to purchase new stock, Citi asserts. The company is guiding to -$5m less in second half marketing than originally planned, which the broker acknowledges partly offsets the earnings impact of the weaker sales.

Morgans downgrades FY18 net profit estimates by -8.7%, although forecasts NZ$192.1m, which is 112% above the prior year. This also includes a forecast for marketing expenditure to more than double.

While reducing forecasts for FY19 and FY20 net profit by -12.2% and -12.1% respectively, Morgans still expects the company to report earnings growth, reflecting wins in market share and increased distribution across geographies, as well as incremental growth from new products and the Fonterra strategic relationship.

While the miss to FY18 revenue is disappointing, Morgans accepts the reasons but points out that, trading on a large peer multiple, there is no room for disappointment in the stock.

Macquarie agrees this slightly disappointing trading update may mean the stock trades at a lower PE ratio in the near term, until the market regains confidence, but the backdrop to FY19 earnings is strong and the growth trajectory should continue.

FNArena's database has four Buy and two Hold ratings. The consensus target is $11.96, suggesting 9.2% upside to the last share price. This compares with $13.80 ahead of the update.